For American expats residing in European countries such as Spain, Portugal, Italy, France, Germany, the Netherlands and Belgium, navigating the complex world of US tax regulations can be challenging. One area that demands particular attention is the Passive Foreign Investment Company (PFIC) rules.
If you are a US expat with investments in foreign mutual funds or exchange-traded funds (ETFs), you could be liable for additional US reporting and tax. However, understanding the criteria that make a foreign investment a PFIC can be tricky.
In this article, we outline what US expats in Europe need to know about PFICs and foreign mutual funds, why they are best avoided, and what the best reporting strategy is if you have them.
What is a PFIC?
A Passive Foreign Investment Company, commonly referred to as a PFIC, is a shared investment fund that operates outside the jurisdiction of the United States. PFICs are an IRS classification, and they encompass various Spanish and other foreign investment funds and some non-US pension accounts.
The original aim of PFIC status was to prevent US taxpayers from evading taxes through investments in foreign accounts and companies not subject to the same regulations as those within the United States. Americans with PFICs are required to report them annually.
A foreign pension or fund is considered a PFIC if it meets one of two IRS tests:
- Income Test: At least 75% of its gross income is derived from passive sources.
- Asset Test: 50% or more of its assets generate passive income.
In practice, this covers most Spanish and other non-US registered mutual funds and many pension plans.
PFICs have particular tax implications for US taxpayers, as their distributions and gains are subject to the PFIC excess distribution regime, which can have higher tax rates than regular income or capital gains taxes. On top of that, PFIC investments do not qualify for preferential capital gains tax rates, meaning the taxes owed on PFIC gains cannot be offset by capital losses.
As an American living in Europe, regardless of how long you have been living abroad or if you become a resident of a foreign country, you will still be required to pay US taxes and abide by PFIC rules. This means you will need to file a US tax return each year, and comply with PFIC reporting requirements to avoid potential penalties for US taxpayers investing in these foreign entities.
Identifying a PFIC
Identifying a Passive Foreign Investment Company (PFIC) involves looking at the underlying investments of an investment fund. Most US-based mutual funds and index funds are typically not considered PFICs, even if they include foreign investments. To qualify as a PFIC, an investment must meet at least one of the criteria listed above (income or asset test) during each taxable year:
It’s important to remember that the tests should be applied annually, and an investment may qualify as a PFIC in one year but not necessarily the following year.
What is Considered Passive income?
The purpose of these tests includes various sources such as:
- dividend payments
- interest, royalties
- annuities
- rental income
- income equivalent to interest
- payments in lieu of dividends.
Additionally, certain types of contracts and asset exchanges, like:
- notional principal contracts
- commodities transactions (e.g., futures)
- foreign currency exchanges
To reiterate, if 75% or more of an entity’s income comes from these sources or if 50% or more of its assets produce passive income, a fund will be categorized as a PFIC.
PFIC examples
The classification of an investment as a PFIC depends on whether it meets the income and asset tests described earlier, but here are some common examples of PFICs:
Foreign Mutual Funds: Mutual funds domiciled outside the United States that primarily invest in passive income-generating assets like stocks, bonds, and other securities can be considered PFICs.
Foreign Holding Companies: Certain foreign corporations that primarily hold passive assets, such as investments in other companies or rental properties, may qualify as PFICs.
Foreign Real Estate Investment Trusts (REITs): REITs based outside the US that generate rental income from real estate holdings could be classified as PFICs.
Offshore Hedge Funds: Hedge funds organized in foreign jurisdictions that primarily engage in passive investment strategies, like index tracking or long-term holdings, can be considered PFICs.
Foreign Exchange-Traded Funds (ETFs): ETFs registered and operated outside the United States that invest in passive income-producing assets may be classified as PFICs.
Foreign Unit Investment Trusts (UITs): UITs established in foreign countries that primarily hold passive investments like bonds or income-generating securities can be PFICs.
PFIC reporting requirements
Passive Foreign Investment Company (PFIC) reporting requirements and rules can be intricate and highly detailed. Generally, if you own shares in a foreign mutual fund, it must be reported to the IRS. Some reporting requirements you may encounter include:
Form 8621: You’ll need to file Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund, for each PFIC you own.
FBAR (Foreign Bank Account Report): If you have foreign financial accounts that meet certain thresholds, you must file an FBAR form to report those accounts.
Form 8938: If you meet the specified criteria, you may also have to file Form 8938, which is a reporting form required by the Foreign Account Tax Compliance Act (FACTA).
Exceptions to filing Form 8621 for American expats include:
There are some exceptions to filing form 8621 they include:
Threshold Exemption: If your total PFIC holdings are below $25,000 and you have not made QEF or MTM elections, you may be exempt from filing Form 8621. However, indirect holdings can complicate eligibility, if you take tax
Foreign Pension Plans: Certain foreign pension plans may be exempt from PFIC reporting until distributions are made. Modifications or early withdrawals could impact the exemption’s validity. Seek guidance from a financial advisor to assess your specific pension plan’s rules.
Taxation of PFICs
There are three different methods for taxing PFICs, and finding the right one for your specific situation can limit any additional US tax liabilities. They are as follows:
Excess Distribution: This is the default taxation method, where the PFIC is classified as a Section 1291 Fund. Under this approach, US taxes on PFIC earnings can be deferred until the earnings are distributed or the PFIC is sold. The excess distribution is spread out over the investment period on a pro-rata basis.
Mark-to-Market (MTM): By electing the MTM method on Form 8621, US expat investors can avoid interest charges and a higher tax burden but will face an earlier tax obligation. With MTM, investors recognize an annual gain or loss based on the PFIC’s value at the end of the tax year. The gain or loss is then taxed as ordinary income or treated as an ordinary income loss.
Qualified Electing Fund (QEF): Another option is the QEF election, which also accelerates the tax liability but reduces potential interest and tax obligations. To use the QEF approach, investors must file Form 8621 in the first year of PFIC investment. However, if the PFIC’s annual information statement is unavailable, the QEF method may not be accessible. With QEF, investors must include a pro-rata portion of the PFIC’s earnings in their annual gross income, which can be classified as ordinary income or capital gains.
Keep in mind though that the MTM and QEF methods have specific limitations and requirements and your choice of taxation method can have a significant impact on your US tax liability.
Understanding the PFIC tax considerations is essential when investing as an American living in Europe to minimize your US tax and reporting liability. To avoid unexpected issues, ensure that you seek guidance from an expat financial advisor in Europe.
This article is for informational purposes only; it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.
